Financial Ratio Analysis: Definition, Types, How to Use and Examples

Understanding your company’s financial health is crucial to success as an investor or business owner. Financial ratio analysis allows you to evaluate financial statements and determine strengths and weaknesses. By calculating and analyzing key financial ratios, you can gain insight into liquidity, efficiency, leverage, profitability, and valuation.

What Is Financial Ratio Analysis?

Financial ratio analysis is a method of assessing a company’s performance and financial health by calculating and evaluating financial ratios derived from a company’s financial statements. These ratios provide insights into a company’s liquidity, profitability, leverage, efficiency, and market value.

To conduct a financial ratio analysis, you first need to gather a company’s financial statements, like the income statement, balance sheet, and cash flow statement. Then, you calculate various financial ratios using numbers from these statements. For example:

• Liquidity ratios measure a company’s ability to pay short-term obligations. The current ratio is calculated as current assets divided by current liabilities.
• Profitability ratios measure a company’s ability to generate profits. The net profit margin is calculated as net income divided by revenue.
• Leverage ratios measure a company’s amount of debt. The debt-to-equity ratio is calculated as total liabilities divided by shareholder’s equity.
• Efficiency ratios measure how well a company utilizes its assets and liabilities. The inventory turnover ratio is calculated as the cost of goods sold divided by the average inventory.
• Market value ratios measure investor sentiment about a company’s stock price. The price-to-earnings ratio is calculated as a company’s stock price divided by earnings per share.

Financial ratio analysis allows you to identify trends over time and compare a company’s financials to industry standards or competitors. Used properly, financial ratios can provide valuable insights into a company’s financial strength, stability, and potential for future achievements or failure. Overall, financial ratio analysis is a useful tool for companies and investors to understand financial performance and make better business or investment decisions.

Key Objectives and Advantages of Ratio Analysis

Ratio analysis is a useful tool for analyzing a company’s financial statements to determine its financial health and performance. There are several key objectives and advantages of conducting ratio analysis:

Insight into Financial Performance

One of the objectives of ratio analysis is to gain insight into a company’s financial performance by analyzing relationships between components of the financial statements. For example, the profit margin ratio indicates how much profit a company generates for every dollar of sales. Monitoring this ratio over time helps determine if financial performance is improving or declining.

Identify Areas of Concern

Also, one of the objectives of ratio analysis is to help identify areas of financial concern or strength.  For example, a high debt-to-equity ratio indicates the company is highly leveraged and may have trouble paying interest costs. A low quick ratio suggests the company may have trouble paying short-term obligations. Identifying these areas of concern allows companies to take corrective action.

Benchmarking

Ratio analysis allows benchmarking a company’s performance against industry competitors or over different periods. For example, comparing a company’s net profit margin over the past 3 years helps determine if it is improving or declining relative to historical performance. Comparing profit margins with industry competitors helps assess if the company is performing better or worse than rivals.

Simplifies Financial Statements

Ratio analysis simplifies complex financial statements into a more understandable format by condensing lines of financial data into a single meaningful ratio. This allows non-financial managers and investors to better understand a company’s financial position and performance.

In summary, ratio analysis is a useful tool that provides insight into a company’s financial health and performance. It helps identify areas of financial concern, allows benchmarking performance, and simplifies financial statements into more understandable metrics. When used properly, ratio analysis can provide a wealth of information about a company’s financial position.

Major Types of Financial Ratios

Financial ratios are useful tools for analyzing a company’s financial statements to determine its financial health and performance. There are three major types of financial ratios:

Liquidity Ratios

Liquidity ratios measure a company’s ability to pay off short-term debts and financial obligations. They determine how easily a company’s assets can be converted into cash. Two common liquidity ratios are:

1. Current ratio 

Calculated as current assets divided by current liabilities. It measures a company’s ability to pay short-term obligations. A higher current ratio means a company is more liquid and has a stronger short-term financial position.

2. Quick ratio 

Calculated as quick assets (cash, marketable securities, receivables) divided by current liabilities. It measures a company’s ability to pay short-term obligations without selling inventory. A higher quick ratio means a company has stronger short-term liquidity.

Leverage Ratios

Leverage ratios measure the extent to which a company uses debt to finance its operations. They determine a company’s financial risk by analyzing the relationship between its debt and equity. Two common leverage ratios are:

1. Debt-to-equity ratio

Calculated as total liabilities divided by shareholders’ equity. It measures the relationship between a company’s total debt and shareholders’ equity. A higher debt-to-equity ratio means a company has been aggressively using debt to finance its growth and may have trouble paying interest or principal payments.

2. Interest coverage ratio

Calculated as earnings before interest and taxes (EBIT) divided by interest expense. It measures a company’s ability to pay interest on its debt. A higher interest coverage ratio means a company has a stronger ability to pay interest charges and take on more debt.

Profitability Ratios

Profitability ratios measure a company’s ability to generate profits relative to its revenue, assets, operating costs, and equity. They determine how efficiently a company is using its resources. Some common profitability ratios are:

• Net profit margin: Calculated as net income divided by revenue. It measures how much profit a company makes for every dollar of revenue. A higher net profit margin means a company is more profitable.
• Return on assets: Calculated as net income divided by total assets. It measures how efficiently a company is using its assets to generate profits. A higher ROA means a company is more profitable relative to its total assets.
• Return on equity: Calculated as net income divided by shareholders’ equity. It measures how much profit a company generates with the money shareholders have invested. A higher ROE means a company is more profitable relative to shareholder’s equity.

How to Calculate and Interpret Financial Ratios

To effectively calculate and interpret financial ratios, follow these steps:

Gather the Necessary Financial Statements

You will need the income statement, balance sheet, and statement of cash flows for the company. These provide the raw data to calculate the ratios. Compare statements over multiple years to analyze trends.

Select the Relevant Ratios

Choose ratios to provide insights into the company’s profitability, liquidity, leverage, efficiency, and valuation. Some of the most common ratios include:

• Return on Assets (ROA): Profitability ratio showing how much profit a company generates from its assets. Higher is better.
• Current Ratio: Liquidity ratio measuring a company’s ability to pay short-term debts. Higher is better, with a ratio over 1 considered good.
• Debt-to-Equity Ratio: Leverage ratio indicates the proportion of debt and equity financing a company uses. Lower is less risky.
• Inventory Turnover: Efficiency ratio showing how many times a company sells and replaces its inventory over a period. Higher indicates more efficient inventory management.
• Price-to-Earnings (P/E) Ratio: Valuation ratio measuring a company’s share price relative to its earnings per share. Lower indicates a potentially undervalued stock.

Calculate the Ratios

Divide the relevant numbers from the financial statements to calculate each ratio. For example, to calculate ROA, divide net income by total assets. Compare ratios to industry averages and the company’s historical ratios.

Analyze the Results

Review the ratios together to get a sense of the company’s overall financial health and potential. Look for any significant changes over time and how the company compares to industry peers. Make a note of any potential risks or opportunities the ratios may indicate to guide investment or lending decisions.

Ratio analysis provides a quantitative assessment of a company’s performance and risks. By following these steps, you can gain valuable insights into a company’s financial position and potential for your investment portfolio or lending decisions. The key is to consider multiple ratios together to get a complete picture of the company’s financial standing and outlook.

Financial Ratio Analysis Examples Using Common Ratios

Financial ratios are mathematical calculations that compare specific financial statement accounts to each other. Ratio analysis is a useful tool to evaluate a company’s performance and financial health. Some of the most common financial ratios used are:

Liquidity Ratios

Liquidity ratios measure a company’s ability to pay its short-term debts and obligations. The current ratio compares current assets to current liabilities. A higher ratio indicates more liquidity and the ability to pay short-term debts. The quick ratio is similar but excludes inventories.

Leverage Ratios

Leverage or debt ratios measure the extent of a company’s indebtedness. The debt-to-equity ratio compares total debt to shareholder’s equity. A higher ratio means more leverage and financial risk. The interest coverage ratio compares earnings before interest and taxes (EBIT) to interest expenses. A lower ratio could mean the company will struggle to pay interest costs.

Profitability Ratios

Profitability ratios measure a company’s ability to generate profits. Gross profit margin compares gross profit to revenue. A higher margin means the company is efficiently controlling costs. Operating profit margin compares operating profit to revenue. Net profit margin compares net income to revenue. Higher margins indicate higher profitability.

Efficiency Ratios

Efficiency ratios measure how well a company is utilizing its assets and resources. Asset turnover ratio compares revenue to total assets. A higher ratio means the company is generating more revenue per dollar of assets. Inventory turnover ratio measures how many times inventory is sold and replaced over a period. A higher ratio means inventory is sold more quickly, reducing holding costs.

Market Prospect Ratios

Market prospect ratios measure investor sentiment and expectations. The price-to-earnings (P/E) ratio compares the stock price to earnings per share. A high P/E suggests investors expect higher future growth and are willing to pay more for a share. P/E is calculated using forecasted earnings for the next year. The earnings yield compares earnings per share to the share price, similar to an interest rate.

In summary, financial ratio analysis provides insight into a company’s financial performance, balance sheet strength, operational efficiency and market expectations. Comparing ratios over time and against industry averages helps evaluate trends and assess how a company is positioned relative to competitors.

Conclusion

Financial ratio analysis is a powerful tool that can provide tremendous insights into a company’s financial health and performance. By regularly reviewing key ratios like the current ratio, quick ratio, debt-to-equity ratio, and interest coverage ratio, you can monitor trends to see if the company is improving or declining. Comparing ratios against industry averages and a company’s own historical results can highlight areas of strength and weakness. Used properly, financial ratio analysis allows you to make smarter decisions about where to invest your money and which companies to do business with. While ratios are not perfect and should be considered in context, they remain one of the most useful ways for you to cut through the complexity of financial statements and see the bigger picture.